U.S. Tax Desk Newsletter - October 2022 (part one)

Background

To address harmful tax competition, the European Union (“EU”) requires Member States to refrain from introducing any new harmful tax measures and amend any laws or practices deemed to be harmful. Regarding non-EU jurisdictions, the EU has also evaluated their tax regimes against international tax standards and put in place a list of noncooperative jurisdictions for tax purposes (“EU List”). In October 2021, the EU placed Hong Kong on the watchlist of the EU List because of the possible risks of double non-taxation arising from the tax exemption for passive offshore income in the absence of any requirement for recipient companies to have a substantial economic presence in Hong Kong. The EU’s primary concern is the possible exploitation of the tax arrangement by shell companies for tax benefits.

To consolidate Hong Kong’s status as an international financial centre, minimize reputational risk arising from non-compliance with international standards and protect Hong Kong businesses against potential defensive measures that may arise from EU decisions; Hong Kong has proposed changes to the offshore regime for passive income.

Guiding principles in refining FSIE regime

The government has recently released a consultation paper on its proposal to refine the FSIE regime. In its consultation paper, the government stated that it would uphold the following principles to protect Hong Kong’s interests:

• Hong Kong will continue to adhere to the territorial source principle of taxation;
• Hong Kong’s simple, certain and low-tax regime will be upheld; and
• The compliance burden will be minimized.

In refining our FSIE regime, the government will give due regard to the EU’s criteria for a non-harmful FSIE regime concerning passive income:

• All types of passive income (i.e. interest, income from intellectual properties (“IP Income”), dividends, and disposal gains in relation to shares or equity interest (“Disposal Gains”) should be covered;
• Adequate economic substance requirement should be imposed on taxpayers receiving tax exemption for non-IP Income; the nexus approach should be adopted in granting the tax exemptions for IP Income; and
• Robust anti-abuse rules should be in place to tackle specific risks of double non-taxation and lack of substantial activities.

Refined FSIE regime

No changes will be made to the FSIE regime concerning active income. The salient features of the refined FSIE regime are summarized below:

• The territorial source principle of taxation will continue to apply in general. Only taxpayers who fail to meet the economic substance requirement of offshore passive non-IP income or fail to comply with the nexus approach for offshore passive IP income will no longer enjoy tax exemption;
• As multinational enterprise (“MNE”) groups[1] have a higher risk of base erosion and profit shifting (“BEPS”), the proposed refinements to our FSIE regime will only affect MNE groups. Local companies with no offshore operation and companies belonging to purely local groups will continue to be exempt from tax on the passive offshore income; and
• Unilateral tax credit will be provided to those taxpayers who have paid taxes in other jurisdictions which have not entered into comprehensive avoidance of double taxation agreement with Hong Kong (“non-CDTA jurisdiction”) as a double taxation relief.

Key changes

Covered income and covered taxpayers

Covered income or in-scope offshore passive income, i.e. interest, IP Income, dividends and Disposal Gains, will be deemed to be sourced from Hong Kong and chargeable to tax if:

• The income is received in Hong Kong by a constituent entity of an MNE group (“covered taxpayer”) irrespective of its revenue or asset size; and
• The recipient entity fails to meet the economic substance requirement for non-IP income or fails to comply with the nexus approach for IP income.

Economic substance requirement

In-scope offshore passive non-IP Income which is received in Hong Kong by a covered taxpayer will continue to be exempt from profits tax if the taxpayer conducts substantial economic activities concerning the relevant passive income in Hong Kong:

• For a taxpayer that is not a pure equity holding company[2], the relevant activities will include making a necessary strategic decision and managing and assuming principal risks in respect of any assets it acquires, holds or disposes of;
• For a taxpayer that is a pure equity holding company, a reduced substantial activities test can be applied such that the relevant activities will only include holding and managing its equity participation and complying with the corporate law filing requirements in Hong Kong; and
• Outsourcing of the relevant activities will be permitted, provided that the taxpayer can demonstrate adequate monitoring of the outsourced activities and that the appropriate are conducted in Hong Kong.

To meet the economic substance requirement, the taxpayer will need to meet the adequacy test in terms of employing an adequate number of qualified employees and incurring an adequate amount of operating expenditures in Hong Kong with the relevant activities. The Inland Revenue Department (“IRD”) will consider the totality of facts of each case, including the nature of the business, the scale of operation, profitability, details of staff employed, the amount and types of operating expenditures incurred etc.

Nexus approach for IP Income

For offshore IP Income, the nexus approach will be applied to determine the extent of exempting such income. Under the nexus approach, only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio which is defined as the qualifying expenditures as a proportion of the overall expenditures that the taxpayer has incurred to develop the IP asset. The proportion of research and development (“R&D”) expenditure is a proxy for substantial economic activities. This seeks to ensure that there is a direct nexus between income-receiving benefits and expenditures contributing to that income. The nexus approach includes the following features:

• Qualifying IP assets only cover patents and other IP assets which are functionally equivalent to patents if those IP assets are both legally protected and subject to similar Proposed changes to the offshore regime for passive income in Hong Kong 4 This newsletter is issued in summary form exclusively for the information of clients of Mazars and others interested in our services and should not be used or relied upon as a substitute for detailed advice or as a basis for formulating business decisions. approval and registration processes. Therefore, marketing-related IP assets (e.g. trademark and copyright) are excluded from preferential tax treatment;
• Qualifying expenditures only include R&D expenditures that are directly connected to the IP asset. Acquisition costs of the IP asset are not considered qualifying expenditures;
• A jurisdiction may permit taxpayers to apply a 30% uplift on the qualifying expenditures subject to the extent that the taxpayer has incurred non-qualifying expenditures; and
• The jurisdictional approach[3] will be adopted for determining the scope of qualifying expenditures to ensure that the IP benefits are commensurate with the relevant domestic R&D activities.

Participation exemption for dividends and Disposal Gains

The government will introduce participation exemption in respect of offshore dividends and Disposal Gains so that the income concerned will continue to be tax-exempted if:

• The investor company is a Hong Kong resident person or a non-Hong Kong resident person that has a permanent establishment (“PE”) in Hong Kong;
• The investor company holds at least 5% of the shares or equity interest in the investee company; and
• No more than 50% of the income derived by the investee company is passive income.

The proposed participation exemption aims to avoid possible double taxation and relieve the compliance burden for claiming relief for double taxation through a tax credit. Anti-abuse rules will be introduced at the same time to prevent non-Hong Kong resident entities having non-nexus with Hong Kong from benefiting from the exemption by use of shell entities:

• Switch-over rule: If the income concerned or profits of the investee company (in the case where the income concerned is dividends) is or are subject to tax in a foreign jurisdiction, the headline tax rate of which is below 15%, the tax relief available to the investor company will switch over from participation exemption to foreign tax credit.
• Main purpose rule: Any arrangement/series of arrangements put in place for the primary purpose or one of the main purposes of obtaining a tax advantage that defeats the object/purpose of the exemption will be ignored.
• Anti-hybrid mismatch rule: Where the income concerned is dividends, participation exemption will not apply to the extent that the dividend payment is deductible by the investee company.

Unilateral tax credit

To maintain Hong Kong’s tax competitiveness and ease the compliance burden for MNE groups, Hong Kong will introduce unilateral tax credit in respect of in-scope offshore passive income to supplement the existing double taxation relief.

Hong Kong will provide a unilateral tax credit to avoid double taxation if a taxpayer fails to get tax exemption but has already paid tax in non-CDTA jurisdiction.

Effective date

The government plan to introduce a bill on the proposed refinements on FSIE regime in October with a view to bringing the changes into force from 1 January 2023.

Mazars' observations 

The proposed changes are intended to prevent the use of shell companies to benefit from tax exemption. However, they could have far-reaching implications. The proposed new rules apply to all types of passive offshore income regardless of the amount of income concerned, the size of the revenue or assets of the taxpayer or the MNE group which the taxpayer belongs. Introducing participation exemption, nexus approach, switch over rule, and anti-hybrid mismatch rule will make Hong Kong's tax system no longer as "simple" as it used to be. It represents a significant change to our existing tax system.

To continue enjoying the tax exemption, the economic substance requirement requires taxpayers to conduct substantial economic activities concerning the relevant income in Hong Kong. While the government stated in the consultation that the source of profits and economic substance requirement would be considered separately, the changes will inevitably affect many offshore claims. In addition, offshore Disposal Gains of a capital nature are not excluded / exempted under the proposed refinements. This may cause capital gain claims for certain offshore Disposal Gains to no longer be available. As preferential tax treatment based on the nexus ratio will only apply to income from qualifying IP assets, offshore royalty income for marketing-related IP assets may not be able to get any tax exemption.

The proposed new regime will only apply to passive offshore income received in Hong Kong. Therefore, foreign passive income, which a covered taxpayer in Hong Kong does not receive, should not be taxable. Hopefully, the amendment bill will spell out clearly how the term will be construed.

MNE groups should review whether they have Hong Kong companies and/or Hong Kong PEs that receive in-scope offshore passive income. If so, assess the current investment structure and mode of operation and consider making necessary adjustments to preserve the exemption status.

[1] "MNE Group" means any group that includes two or more enterprises the tax residence for which is in different jurisdictions or includes an enterprise that is resident for tax purpose in one jurisdiction and is subject to tax with respect to the business carried out through a permanent establishment in another jurisdiction.
[2] "Pure equity holding company" means a company which, as its primary function, acquires and holds shares and equitable interests in companies and only earns dividends and disposal gains in relation to shares or equity interest.
[3] Under jurisdictional approach, qualifying expenditures cover the expenditures on R&D activities (a) undertaken by the taxpayer within the jurisdiction providing the IP regime ("IP regime jurisdiction"); (b) outsourced to unrelated parties to take place inside or outside the IP regime jurisdiction; and (c) outsourced to resident related parties to take place within the IP regime jurisdiction.